FHA financing and loan assumption

This post contains specific advice that in the future will either help you sell your house faster and easier or for more money.

Utilize fixed-rate assumable financing: Government entities like FHA, VA, GNMA or some other official government program (not Freddie or Fannie) provide assumable, fixed-rate loans desired by your future buyer.

Maximize your down payment (within reason)

I am not advocating FHA loans because they allow you to put down as little as 3.5%. I believe you should minimize your time to payoff by optimizing (generally enlarging) your down payment and utilizing accelerated amortization. Nor am I advocating emptying savings accounts and failing to keep liquid reserves or other investments. The middle road I advocate leads to financial freedom, whereas the road of maximum debt leads to deflation through individual financial disaster. The debt road is well traveled, but like Robert Frost poetically noted,

Two roads diverged in a wood, and I—
I took the one less traveled by,
And that has made all the difference.

Money-changers chastise me for advising borrowers to eliminate debt when cheap money abounds. They contend debt is great as long as the borrower’s back can bear the payments; similarly, cancer is great as long as the medication can treat the patient. Compound interest grows like cancer, and both are best avoided or annihilated.

Debt is like fat; it is an excess carried around as reminder of glories and gluttonies past. Go lean, purge cancerous debt and grow your net worth; wealth isn’t going to appear through home-price appreciation for the next decade, so paying down debt is the best opportunity available for consistently improving your financial life. It isn’t a Ponzi Scheme. Take advantage of it.

Expect no home-price appreciation

No meaningful appreciation will occur in the decade of the twenty-teens. The majority of knife catchers and much of the market participation over the next two years will be those who cling to beliefs of past appreciation coupled with those who don’t believe prices will remain flat. The activity of knife catchers will provide liquidity as prices continue their controlled decent.

Some will buy without expectation of appreciation — certainly those who follow my writing expect very little — and if prices do appreciate, those not motivated by appreciation will consider it a bonus.

Assumption of Mortgage

Despite the apparent lack of price appreciation, there is still a method for obtaining financing equity from property from a little-known and oft-forgotten loan term known as assumption.

Assumption of mortgage is the purchase of mortgaged property whereby the buyer accepts liability for the debt that continues to exist.

To be more precise, the borrower is assuming both the rights and obligations of the promissory note and the Deed of Trust. Assumable loans have been around as long as lending. Borrowers seeking release from their payment obligations usually sell for cash and terminate the loan; nonetheless, a qualified new buyer may assume the previous borrower’s liability and simply take over making payments on the loan.

Lenders despise mortgage assumptions (and they should)

Both buyers and sellers benefit from assumption, but lenders suffer — which is why assumption is generally limited to government programs and adjustable-rate mortgages; lenders do not want their fixed-rate loans assumed.

Lenders borrow short to lend long; in other words, when they underwrite you a 30-year loan, they obtain the money they loan you with short-term borrowing, mostly from savings accounts, maybe even your own. In the industry this problem is known as an asset-liability mismatch. If lenders have a portfolio of low-interest loans outstanding in a high interest rate borrowing environment, they experience a negative spread, and eventually go bankrupt. In fact, much blame for the Savings and Loan fiasco traces back to a negative spread condition and asset-liability mismatch during the early 80s.

Rather than letting thrifts die, we deregulated and allowed them to build taxpayer insured Ponzi Schemes prompting a massive government bailout. The Savings and Loan industry collapse was the early warning of problems with banking deregulation — not all deregulation is good; for instance repeal of the Glass–Steagall Act was a disaster as it enabled the conditions that contributed to our global Ponzi Scheme that collapsed in late 2008.

In rising interest-rate environments lender spreads are squeezed but not eliminated as older, low-interest loans are replaced with newer, high-interest loans. If all loans were assumable, lenders would be handicapped in their ability to rematch their assets and liabilities. To avoid asset-liability mismatch, lenders put due-on-sale clauses in their promissory notes specifically to prevent low-interest loans from surviving to term with a series of debt-assuming owners.

Fortunately for buyers, the federal government cares not about making a profit or cost of financing, and they hold loans to term; as a result, assumable loans are underwritten to standards compliant with FHA or other government programs and insured by same.

Unfortunately for taxpayers, A rising FHA default rate foreshadows a crush of foreclosures and the US taxpayer will be called upon to pay billions in losses for a government policy to keep the house prices artificially high. The taxpayer losses represent the loss burden lenders shifted to us and the moral hazard we are enabling for the future. You should feel defrauded… again.

Understanding by example

A buyer looking at properties like today’s will spend nearly $4,000 a month paying down a 30-year mortgage on a $900,000 house (current FHA loan cap is $729,750 in Irvine). Fast forward ten years, and the future buyer of this property will likely be able to afford a $6,000 monthly payment, but since interest rates will also be higher, the mortgage is not larger, and thereby, prices are not higher. As I mentioned in, A Theory of House Prices and Housing Markets, expanding mortgage balances are necessary for prices to appreciate, and rising interest rates cause mortgage balances to contract rather than expand. In fact, if interest rates move higher faster than wages, prices decline.

If a future buyer is spending $6,000 per month to borrow the same amount that $4,000 supports today, then the future buyer would be $2,000 a month better off by assuming the old loan at 5% rather than underwriting a new one at 9% or higher. It is the desirability of the low payment on the old loan that makes assumption work.

Any rational buyer would want to assume a loan with lower payments and fewer than 30 years remaining to pay. The only downside for a buyer is that they will never refinance into a lower interest loan simply because they already have one. I have written many times about the virtue of buying when interest rates are high and refinancing into a lower interest rate to accelerating amortization. Buyers obtain this same benefit through assumption, and sellers can extract value from the transaction.

Seeing this potential outcome in advance will help you position yourself to take full advantage. Most fixed-rate private loans — including those issued by GSEs — are not assumable, and borrowers who utilize financing today with due-on-sale clauses will have no opportunity to extract value from their financing.

Sell faster or sell for more

If interest rates rise, assumable fixed-rate financing has value even if the financing has not been in place long. For instance, if a buyer must become a seller two or three years into their mortgage — and if they have equity and can sell — they will have a significant advantage over sellers with similar properties who do not have assumable loans. A few years from now, the lower mortgage payment will be an attractive feature prompting buyers to select one property over a neighboring one. If you faced two competing properties but one offered an assumable loan that reduces your payments 5%-10%, all things being equal, wouldn’t you chose the one with the lower payment? I would.

As interest rates go up and time passes (which reduces remaining amortization), an assuming owner enjoys monthly savings and a shorter amortization schedule. At first, this is merely a sales point, but at eventually, the benefits accruing an assuming owner morphs into a source of real monetary value a seller can obtain.

How to use owner financing to obtain equity from assumable loans

There are three primary ways owners obtain direct and measurable financial value from their assumable loan:

Buyer increases down payment and pays more total dollars

Seller offers and buyer accepts a seller-financed second mortgage and the seller either keeps the cashflow or discounts the loan in the secondary market and obtains a one-time cash infusion.

The first concept — buyers increasing their down payment and paying more total dollars — should be familiar to anyone who has prepaid interest points when originating a loan. People frequently pay interest up-front in order to lower their interest rate and monthly payments over the life of the loan. When a buyer assumes a seller’s low interest-rate loan, they are doing the same thing, but instead of that money going to a lender (or mortgage broker) that money accrues to the seller. Do you see why lenders hate assumption?

The second and third concepts — issuing seller financing as either a second mortgage or wrap-around mortgage — are far less common and much more complicated, but the financial rewards are great, and any seller with an aging and assumable first mortgage should explore the options assumable financing creates.

Seller financed second mortgages

Let’s go back to the opening example of a loan issued today with a $4,000 monthly payment. Fast-forward to 2020, and the same loan balance financed at 9% yields a $6,000 a month payment. Obviously, a buyer would prefer the $4,000 payment to a $6,000 one, and the seller would like to extract the equity accumulated through paying down the loan balance plus a premium for the value of their financing.

If the seller allowed themselves to be taken out by a buyer using a conventional loan, they would obtain the $138,619 in financing equity obtained by paying down their mortgage debt, and at the closing, the sales price would show no change, and the seller would obtain a check for their financing equity minus fees. However, If the seller offers and the buyer agrees to a second mortgage with a $2,000 payment for a 15-year term at 9%, the seller would obtained an annuity worth $197,186 when the loan balance has only been paid down $138,619 for a value-added of $58,567 or about 8%.

(The annuity value of a $2,000 monthly payment over 15 years discounted at 9% is $197,186)

Why would a buyer agree to this? Well, if you were buying this property in 2020, you are still paying $6,000 a month, so you are no worse off on a monthly payment basis, and your total debt is the same, so you are no worse off on a total debt basis; however, and this is a big however, you will have one loan on a 15-year amortization schedule and another with 20 years remaining out of 30 — you have just accelerated your amortization and reduced your Time to Payoff. I would take such a deal, wouldn’t you?

Both buyer and seller benefit greatly from assumption; only lenders dislike it.

Wrap-around mortgages

Wikipedia’s description is well written, so I relay it in full here:

A wrap-around mortgage, more-commonly known as a “wrap”, is a form of secondary financing for the purchase of real property. The seller extends to the buyer a junior mortgage which wraps around and exists in addition to any superior mortgages already secured by the property. Under a wrap, a seller accepts a secured promissory note from the buyer for the amount due on the underlying mortgage plus an amount up to the remaining purchase money balance.

The new purchaser makes monthly payments to the seller, who is then responsible for making the payments to the underlying mortgagee(s). Should the new purchaser default on those payments, the seller then has the right of foreclosure to recapture the subject property.

Because wraps are a form of seller-financing, they have the effect of lowering the barriers to ownership of real property; they also can expedite the process of purchasing a home. An example:

The seller, who has the original mortgage sells his home with the existing first mortgage in place and a second mortgage which he “carries back” from the buyer. The mortgage he takes from the buyer is for the amount of the first mortgage plus a negotiated amount less than or up to the sales price, minus any down payment and closing costs. The monthly payments are made by the buyer to the seller, who then continues to pay the first mortgage with the proceeds. When the buyer either sells or refinances the property, all mortgages are paid off in full, with the seller entitled to the difference in the payoff of the wrap and any underlying loan payoffs.

Typically, the seller also charges a spread. For example, a seller may have a mortgage at 6% and sell the property at a rate of 8% on a wraparound mortgage. He then would be making a 2% spread on the payments each month (roughly, anyway. The difference in principal amounts and amortization schedules will affect the actual spread made).

As title is actually transferred from seller to buyer, wraparound mortgage transactions will violate the due-on-sale clause of the underlying mortgage, if such a clause is present.

Note that pesky due-on-sale clause is back. Lenders do not like wraps any more than they like assumption and they dislike it for the same reasons, asset-liability mismatch.

Facts about loan assumptions

I wrote to Soylent Green Is People with help in writing this post, and he provided me the following list of facts about assumption:

Assumptions do not require a down payment. If the seller has equity it’s paid to the seller. If the loan is break even to value to upside down, it’s simply taken over.

Assumptions do not (for the most part) require appraisals. It depends on the investor. An FHA insured loan would not require an appraisal, a private investor ARM loan would.

Credit qualifying is based on underwriting standards available at that time. Income, assets, credit, and debt to income ratios apply.

Condo project HOA’s are not re-evaluated. If an FHA loan was made in an association that was acceptable at origination but has since deteriorated, it is of no issue to the assumption department. Since the borrower must credit qualify for the assumption, the current HOA dues might impact the buyers ability to qualify, but that’s the absolute depth of scrutiny these loan applicants will get.

“All in” lender costs to assume is about $1,500 per transaction. It is not a scalable fee. There will be escrow, title, and other non lender costs, but minimal at best.

The loan must be originated and in place for 12 months before an assumption can be completed.

The seller or borrower must pay any escrow shortage/past due interest.

These are our current guidelines, subject to change of course, and not applicable to every lender, but likely similar to what everyone else has as policy.

We get “many” requests to assume, but are closing 1-2 per month. I’d say this is likely due to below market financing available today. Most vintage 2005- 2008 FHA loans were priced in the high 5’s. 2009 FHA loans do not have 12 month seasoning yet. Project forward into 2011-2012 – if we aren’t all wiped out from the planetary alignment/Mayan calendar event…. I’d guess there will be plenty of cheap rates available for buyers willing to purchase FHA financed homes through assumption of the original note.

The GSEs will underwrite ARMs with assumability, but since they are ARMs, the assuming buyer is not locked in to a low rate, so it becomes worthless and pointless. Assuming an ARM does not work like assuming a fixed loan. Don’t mistake one for the other. You want to take out an assumable fixed-rate loan.

Make sure your financing is fixed and assumable

As I stated at the opening of this post, this may be among the most valuable pieces of advice I have offered at the IHB. Fixed-rate financing that allows assumption is the best — and absent appreciation, the only — method of extracting value from real estate going forward.

Use it.

I will.

2011 update

In the two years after this post was written, the FHA increased the cost of their insurance so much as to make this advice less certain. Carefully examine the cost of FHA financing before using it.